Interest Rates and Monetary Policy

Transcription

1 33 IN THIS CHAPTER YOU WILL LEARN: 1 How the equilibrium interest rate is determined in the market for money. 2 The goals and tools of monetary policy. 3 About the Federal funds rate and how the Fed controls it. 4 The mechanisms by which monetary policy affects GDP and the price level. 5 The effectiveness of monetary policy and its shortcomings. Interest Rates and Monetary Policy Some newspaper commentators have stated that the chairman of the Federal Reserve Board (previously Alan Greenspan and now Ben Bernanke) is the second most powerful person in the United States, after the U.S. president. That is undoubtedly an exaggeration because the chair has only a single vote on the 7-person Federal Reserve Board and 12-person Federal Open Market Committee. But there can be no doubt about the chair s influence, the overall importance of the Federal Reserve, and the monetary policy that it conducts. Such policy consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy. The goal is to achieve and maintain price-level stability, full employment, and economic growth. 660

2 Interest Rates The Fed s primary influence is on the money supply and interest rates. Interest rates can be thought of in several ways. Most basically, interest is the price paid for the use of money. It is also the price that borrowers need to pay lenders for transferring purchasing power to the future. And it can be thought of as the amount of money that must be paid for the use of $1 for 1 year. Although there are many different interest rates that vary by purpose, size, risk, maturity, and taxability, we will simply speak of the interest rate unless stated otherwise. Let s see how the interest rate is determined. Because it is a price, we again turn to demand and supply analysis for the answer. The Demand for Money Why does the public want to hold some of its wealth as money? There are two main reasons: to make purchases with it and to hold it as an asset. Transactions Demand, D t People hold money because it is convenient for purchasing goods and services. Households usually are paid once a week, every 2 weeks, or monthly, whereas their expenditures are less predictable and typically more frequent. So households must have enough money on hand to buy groceries and pay mortgage and utility bills. Nor are business revenues and expenditures simultaneous. Businesses need to have money available to pay for labor, materials, power, and other inputs. The demand for money as a medium of exchange is called the transactions demand for money. The level of nominal GDP is the main determinant of the amount of money demanded for transactions. The larger the total money value of all goods and services exchanged in the economy, the larger the amount of money needed to negotiate those transactions. The transactions demand for money varies directly with nominal GDP. We specify nominal GDP because households and firms will want more money for transactions if prices rise or if real output increases. In both instances a larger dollar volume will be needed to accomplish the desired transactions. In Figure 33.1 a (Key Graph) we graph the quantity of money demanded for transactions against the interest rate. For simplicity, let s assume that the amount demanded depends exclusively on the level of nominal GDP and is independent of the interest rate. (In reality, higher interest rates are associated with slightly lower volumes of money demanded for transactions.) Our simplifying assumption allows us to graph the transactions demand, D t, as a vertical line. This demand curve is positioned at $100 billion, on CHAPTER 33 Interest Rates and Monetary Policy 661 the assumption that each dollar held for transactions purposes is spent on an average of three times per year and that nominal GDP is $300 billion. Thus the public needs $100 billion ( $300 billion 3) to purchase that GDP. Asset Demand, D a The second reason for holding money derives from money s function as a store of value. People may hold their financial assets in many forms, including corporate stocks, corporate or government bonds, or money. To the extent they want to hold money as an asset, there is an asset demand for money. People like to hold some of their financial assets as money (apart from using it to buy goods and services) because money is the most liquid of all financial assets; it is immediately usable for purchasing other assets when opportunities arise. Money is also an attractive asset to hold when the prices of other assets such as bonds are expected to decline. For example, when the price of a bond falls, the bondholder who sells the bond prior to the payback date of the full principal will suffer a loss (called a capital loss). s That loss will par- tially or fully offset the interest received on the bond. There is no such risk of capital loss in holding money. The disadvantage of holding money as an asset is that it earns no or very little interest. Checkable deposits pay either no interest or lower interest rates than bonds. Currency itself earns no interest at all. Knowing these advantages and disadvantages, the public must decide how much of its financial assets to hold as money, rather than other assets such as bonds. The answer depends primarily on the rate of interest. A household or a business incurs an opportunity cost when it holds money; in both cases, interest income is forgone or sacrificed. If a bond pays 6 percent interest, for example, holding $100 as cash or in a noninterest checkable account costs $6 per year of forgone income. The amount of money demanded as an asset therefore varies inversely with the rate of interest (which is the opportunity cost of holding money as an asset). When the interest rate rises, being liquid and avoiding capital losses becomes more costly. The public reacts by reducing its ORIGIN OF THE IDEA O 33.1 Liquidity preference holdings of money as an asset. When the interest rate falls, the cost of being liquid and avoiding capital losses also declines. The public therefore increases the amount of financial assets that it wants to hold as money. This inverse relationship just described is shown by D a in Figure 33.1b. Total Money Demand, D m As shown in Figure 33.1, we find the total demand for money, D m, by

3 keygraph FIGURE 33.1 The demand for money, the supply of money, and the equilibrium interest rate. The total demand for money D m is determined by horizontally adding the asset demand for money D a to the transactions demand D t. The transactions demand is vertical because it is assumed to depend on nominal GDP rather than on the interest rate. The asset demand varies inversely with the interest rate because of the opportunity cost involved in holding currency and checkable deposits that pay no interest or very low interest. Combining the money supply (stock) S m with the total money demand D m portrays the market for money and determines the equilibrium interest rate i e. Rate of interest, i (percent) Amount of money demanded (billions of dollars) (a) Transactions demand for money, D t Rate of interest, i (percent) Amount of money demanded (billions of dollars) (b) Asset demand for money, D a Rate of interest, i (percent) D t D a D m i e S m Amount of money demanded and supplied (billions of dollars) (c) Total demand for money, D m = D t + D a, and supply of money QUICK QUIZ FOR FIGURE In this graph, at the interest rate i e (5 percent): a. the amount of money demanded as an asset is $50 billion. b. the amount of money demanded for transactions is $200 billion. c. bond prices will decline. d. $100 billion is demanded for transactions, $100 billion is demanded as an asset, and the money supply is $200 billion. 2. In this graph, at an interest rate of 10 percent: a. no money will be demanded as an asset. b. total money demanded will be $200 billion. c. the Federal Reserve will supply $100 billion of money. d. there will be a $100 billion shortage of money. 3. Curve D a slopes downward because: a. lower interest rates increase the opportunity cost of holding money. b. lower interest rates reduce the opportunity cost of holding money. c. the asset demand for money varies directly (positively) with the interest rate. d. the transactions-demand -for -mon oney curve is perfectly vertical. 4. Suppose the supply of money declines to $100 billion. The equilibrium interest rate would: a. fall, the amount of money demanded for transactions would rise, and the amount of money demanded as an asset would decline. b. rise, and the amounts of money demanded both for transactions and as an asset would fall. c. fall, and the amounts of money demanded both for transactions and as an asset would increase. d. rise, the amount of money demanded for transactions would be unchanged, and the amount of money demanded as an asset would decline. Answers: 1. d; 2. a; 3. b; 4. d horizontally adding the asset demand to the transactions demand.the resulting downward-sloping line in Figure 33.1c represents the total amount of money the public wants to hold, both for transactions and as an asset, at each possible interest rate. Recall that the transactions demand for money depends on the nominal GDP. A change in the nominal GDP working through the transactions demand for money will shift the total money demand curve. Specifically, an increase WORKED PROBLEMS in nominal GDP means that the public wants to W 33.1 hold a larger amount of Demand for money money for transactions, and that extra demand will shift the total money demand curve to the right. In contrast, a decline in the nominal GDP will shift the total money demand curve to the left. As an example, suppose nominal GDP increases from $300 billion to $450 billion 662

4 CHAPTER 33 Interest Rates and Monetary Policy 663 and the average dollar held for transactions is still spent three times per year. Then the transactions demand curve will shift from $100 billion ( $300 billion 3) to $150 billion ( $450 billion 3). The total money demand curve will then lie $50 billion farther to the right at each possible interest rate. The Equilibrium Interest Rate We can combine the demand for money with the supply of INTERACTIVE GRAPHS G 33.1 Equilibrium interest rate money to determine the equilibrium rate of interest. In Figure 33.1c, the vertical line, S m, represents the money supply. It is a vertical line because the monetary authorities and financial institutions have provided the economy with some particular stock of money. Here it is $200 billion. Just as in a product market or a resource market, the intersection of demand and supply determines the equilibrium price in the market for money. Here, the equilibrium price is the interest rate ( i e ) the price that is paid for the use of money over some time period. Changes in the demand for money, the supply of money, or both can change the equilibrium interest rate. For reasons that will soon become apparent, we are most interested in changes in the supply of money. The important generalization is this: An increase in the supply of money will lower the equilibrium interest rate; a decrease in the supply of money will raise the equilibrium interest rate. (Key Questions 1 and 2) Interest Rates and Bond Prices Interest rates and bond prices are inversely related. When the interest rate increases, bond prices fall; when the interest rate falls, bond prices rise. Why so? First understand that bonds are bought and sold in financial markets and that the price of bonds is determined by bond demand and bond supply. Suppose that a bond with no expiration date pays a fixed $50 annual interest payment and is selling for its face value of $1000. The interest yield on this bond is 5 percent: $50 5% interest yield $1000 Now suppose the interest rate in the economy rises to 7 1_ 2 percent from 5 percent. Newly issued bonds will pay $75 per $1000 lent. Older bonds paying only $50 will not be salable at their $1000 face value. To compete with the 7 1_ 2 percent bond, the price of this bond will need to fall to $667 to remain competitive. The $50 fixed annual interest payment will then yield 7 1_ percent to whoever 2 buys the bond: $50 $ _ 2 % Next suppose that the interest rate falls to 2 1_ percent from 2 the original 5 percent. Newly issued bonds will pay $25 on $1000 loaned. A bond paying $50 will be highly attractive. Bond buyers will bid up its price to $2000, at which price the yield will equal 2 1_ percent: 2 $50 $ _ 2 % The point is that bond prices fall when the interest rate rises and rise when the interest rate falls. There is an inverse relationship between the interest rate WORKED PROBLEMS W 33.2 and bond prices. (Key Bond prices and interest rates Question 3) QUICK REVIEW 33.1 People demand money for transaction and asset purposes. The total demand for money is the sum of the transactions and asset demands; it is graphed as an inverse relationship (downward-sloping line) between the interest rate and the quantity of money demanded. The equilibrium interest rate is determined by money demand and supply; it occurs when people are willing to hold the exact amount of money being supplied by the monetary authorities. Interest rates and bond prices are inversely related. The Consolidated Balance Sheet of the Federal Reserve Banks With this basic understanding of interest rates, we can turn to monetary policy, which relies on changes in interest rates to be effective. The 12 Federal Reserve Banks together constitute the U.S. central bank, nicknamed the Fed. (Global Perspective 33.1 also lists some of the other central banks in the world, along with their nicknames.) The Fed s balance sheet helps us consider how the Fed conducts monetary policy. Table 33.1 consolidates the pertinent assets and liabilities of the 12 Federal Reserve Banks as of February 14, You will see that some of the Fed s assets and liabilities differ from those found on the balance sheet of a commercial bank.

5 664 PART EIGHT Money, Banking, and Monetary Policy TABLE 33.1 Consolidated Balance Sheet of the 12 Federal Reserve Banks, February 14, 2008 (in Millions) Assets Liabilities and Net Worth Securities $713,369 Reserves of commercial banks $ 11,312 Loans to commercial banks 60,039 Treasury deposits 4,979 All other assets 111,689 Federal Reserve Notes (outstanding) 778,937 All other liabilities and net worth 89,869 Total 885,097 Total 885,097 Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008, GLOBAL PERSPECTIVE 33.1 Central Banks, Selected Nations The monetary policies of the world s major central banks are often in the international news. Here are some of their offi cial names, along with a few of their popular nicknames. Australia: Reserve Bank of Australia (RBA) Canada: Bank of Canada Euro Zone: European Central Bank (ECB) Japan: The Bank of Japan (BOJ) Mexico: Banco de Mexico (Mex Bank) Russia: Central Bank of Russia Sweden: Sveriges Riksbank United Kingdom: Bank of England United States: Federal Reserve System (the Fed ) (12 regional Federal Reserve Banks) Assets The two main assets of the Federal Reserve Banks are securities and loans to commercial banks. (Again, we will simplify by referring only to commercial banks, even though the analysis also applies to thrifts savings and loans, mu- tual savings banks, and credit unions.) Securities The securities shown in Table 33.1 are government bonds that have been purchased by the Federal Reserve Banks. They consist largely of Treasury bills (short-term securities), Treasury notes (mid-term securities), and Treasury bonds (long-term securities) issued by the U.S. government to finance past budget deficits. These securities are part of the public debt the money borrowed by the Federal government. The Federal Reserve Banks bought these securities from commercial banks and the public through open-market operations. Although they are an important source of interest income to the Federal Reserve Banks, they are mainly bought and sold to influence the size of commercial bank reserves and, therefore, the ability of those banks to create money by lending. Loans to Commercial Banks For reasons that will soon become clear, commercial banks occasionally borrow from Federal Reserve Banks. The IOUs that commercial banks give these bankers banks in return for loans are listed on the Federal Reserve balance sheet as Loans to commercial banks. They are assets to the Fed because they are claims against the commercial banks. To commercial banks, of course, these loans are liabilities in that they must be repaid. Through borrowing in this way, commercial banks can increase their reserves. Liabilities On the liabilities and net worth side of the Fed s consolidated balance sheet, three entries are noteworthy: reserves, Treasury deposits, and Federal Reserve Notes. Reserves of Commercial Banks The Fed requires that the commercial banks hold reserves against their checkable deposits. When held in the Federal Reserve Banks, these reserves are listed as a liability on the Fed s balance sheet. They are assets on the books of the commercial banks, which still own them even though they are deposited at the Federal Reserve Banks. Treasury Deposits The U.S. Treasury keeps deposits in the Federal Reserve Banks and draws checks on them to pay its obligations. To the Treasury these deposits are assets; to the Federal Reserve Banks they are liabilities. The Treasury creates and replenishes these deposits by depositing tax receipts and money borrowed from the public or from the commercial banks through the sale of bonds. Federal Reserve Notes Outstanding As we have seen, the supply of paper money in the United States consists of Federal Reserve Notes issued by the Federal

6 CHAPTER 33 Interest Rates and Monetary Policy 665 Reserve Banks. When this money is circulating outside the Federal Reserve Banks, it constitutes claims against the assets of the Federal Reserve Banks. The Fed thus treats these notes as a liability. Tools of Monetary Policy With this look at the Federal Reserve Banks con- ORIGIN OF THE IDEA O 33.2 solidated balance sheet, Tools of monetary policy we can now explore how the Fed can influence the money-creating abilities of the commercial banking system. The Fed has four tools of monetary control it can use to alter the reserves of commercial banks: Open-market operations The reserve ratio The discount rate The term auction facility Open-Market Operations Bond markets are open to all buyers and sellers of corporate and government bonds (securities). The Federal Reserve is the largest single holder of U.S. government securities. The U.S. government, not the Fed, issued these Treasury bills, Treasury notes, and Treasury bonds to finance past budget deficits. Over the decades, the Fed has purchased these securities from major financial institutions that buy and sell government and corporate securities for themselves or their customers. The Fed s open-market operations consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the general public. (The Fed actually buys and sells the government bonds to commercial banks and the public through two dozen or so large financial firms, called primary dealers. ) Openmarket operations are the Fed s most important day-to-day instrument for influencing the money supply. Buying Securities Suppose that the Fed decides to have the Federal Reserve Banks buy government bonds. They can purchase these bonds either from commercial banks or from the public. In both cases the reserves of the commercial banks will increase. From Commercial Banks When Federal Reserve Banks buy government bonds from commercial banks, (a) The commercial banks give up part of their holdings of securities (the government bonds) to the Federal Reserve Banks. (b) The Federal Reserve Banks, in paying for these securities, place newly created reserves in the accounts of the commercial banks at the Fed. (These reserves are created out of thin air, so to speak!) The reserves of the commercial banks go up by the amount of the purchase of the securities. We show these outcomes as ( a) and (b) on the following consolidated balance sheets of the commercial banks and the Federal Reserve Banks: Assets Securities (a) (a) Securities Assets Securities (a) Reserves (b) Fed Buys Bonds from Commercial Banks Federal Reserve Banks Commercial Banks Liabilities and net worth Reserves of commercial banks (b) (b) Reserves Liabilities and net worth The upward arrow shows that securities have moved from the commercial banks to the Federal Reserve Banks. So we enter Securities (minus securities) in the asset column of the balance sheet of the commercial banks. For the same reason, we enter Securities in the asset column of the balance sheet of the Federal Reserve Banks. The downward arrow indicates that the Federal Reserve Banks have provided reserves to the commercial banks. So we enter Reserves in the asset column of the balance sheet for the commercial banks. In the liability column of the balance sheet of the Federal Reserve Banks, the plus sign indicates that although commercial bank reserves have increased, they are a liability to the Federal Reserve Banks because the reserves are owned by the commercial banks. What is most important about this transaction is that when Federal Reserve Banks purchase securities from commercial banks, they increase the reserves in the banking system, which then increases the lending ability of the commercial banks. From the Public The effect on commercial bank reserves is much the same when Federal Reserve Banks purchase securities from the general public. Suppose the

7 666 PART EIGHT Money, Banking, and Monetary Policy FIGURE 33.2 The Federal Reserve s purchase of bonds and the expansion of the money supply. Assuming all banks are loaned up initially, a Federal Reserve purchase of a $1000 bond from either a commercial bank or the public can increase the money supply by $5000 when the reserve ratio is 20 percent. In the left panel of the diagram, the purchase of a $1000 bond from a commercial bank creates $1000 of excess reserves that support a $5000 expansion of checkable deposits through loans. In the right panel, the purchase of a $1000 bond from the public creates a $1000 checkable deposit but only $800 of excess reserves because $200 of reserves is required to back up the $1000 new checkable deposit. The commercial banks can therefore expand the money supply by only $4000 by making loans. This $4000 of checkable-deposit money plus the new checkable deposit of $1000 equals $5000 of new money. 2. New reserves 1. Fed buys $1000 bond from a commercial bank $1000 Excess reserves 3. New reserves 4. $200 $800 Excess reserves (required reserves) 1. Fed buys $1000 bond from the public $5000 Bank system lending $4000 Bank system lending 2. $1000 initial checkable deposit 3. Total increase in money supply ($5000) 5. Total increase in money supply ($5000) Gristly Meat Packing Company has government bonds that it sells in the open market to the Federal Reserve Banks. The transaction has several elements: (a) Gristly gives up securities to the Federal Reserve Banks and gets in payment a check drawn by the Federal Reserve Banks on themselves. (b) Gristly promptly deposits the check in its account with the Wahoo bank. ( c) The Wahoo bank sends this check against the Federal Reserve Banks to a Federal Reserve Bank for collection. As a result, the Wahoo bank enjoys an increase in its reserves. To keep things simple, we will dispense with showing the balance sheet changes resulting from the Fed s sale or purchase of bonds from the public. But two aspects of this transaction are particularly important. First, as with Federal Reserve purchases of securities directly from commercial banks, the purchases of securities from the public increase the lending ability of the commercial banking system. Second, the supply of money is directly increased by the Federal Reserve Banks purchase of government bonds (aside from any expansion of the money supply that may occur from the increase in commercial bank reserves). This direct increase in the money supply has taken the form of an increased amount of checkable deposits in the economy as a result of Gristly s deposit. The Federal Reserve Banks purchases of securities from the commercial banking system differ slightly from their purchases of securities from the public. If we assume that all commercial banks are loaned up initially, Federal Reserve bond purchases from commercial banks increase the actual reserves and excess reserves of commercial banks by the entire amount of the bond purchases. As shown in the left panel in Figure 33.2, a $1000 bond purchase from a commercial bank increases both the actual and the excess reserves of the commercial bank by $1000. In contrast, Federal Reserve Bank purchases of bonds from the public increase actual reserves but also increase checkable deposits when the sellers place the Fed s check into their personal checking accounts. Thus, a $1000 bond purchase from the public would increase checkable deposits by $1000 and hence the actual reserves of the loaned-up banking system by the same amount. But with a 20 percent reserve ratio applied to the $1000 checkable deposit, the excess reserves of the banking system would be only $800 since $200 of the $1000 would have to be held as reserves. However, in both transactions the end result is the same: When Federal Reserve Banks buy securities in the open market, commercial banks reserves are increased. When the banks lend out an amount equal to their excess reserves, WORKED PROBLEMS W 33.3 Open-market operations the nation s money supply will rise. Observe in Figure 33.2 that a $1000 purchase of bonds by the Federal Reserve results in a potential of $5000 of additional money, regardless of whether the purchase was made from commercial banks or from the general public. Selling Securities As you may suspect, when the Federal Reserve Banks sell government bonds, commercial banks reserves are reduced. Let s see why.

8 CHAPTER 33 Interest Rates and Monetary Policy 667 To C o m m e r c i al Banks When the Federal Reserve Banks sell securities in the open market to commercial banks, (a) The Federal Reserve Banks give up securities that the commercial banks acquire. (b) The commercial banks pay for those securities by drawing checks against their deposits that is, against their reserves in Federal Reserve Banks. The Fed collects on those checks by reducing the commercial banks reserves accordingly. The balance-sheet changes again identified by (a) and (b) appear as shown below. The reduction in commercial bank reserves is indicated by the minus signs before the appropriate entries. Assets Securities (a) Assets Reserves (b) Securities (a) Fed Sells Bonds to Commerical Banks Federal Reserve Banks Commercial Banks Liabilities and net worth Reserves of commercial banks (b) (a) Securities ( b) Reserves Liabilities and net worth To the Public When the Federal Reserve Banks sell securities to the public, the outcome is much the same. Let s put the Gristly Company on the buying end of government bonds that the Federal Reserve Banks are selling: (a) The Federal Reserve Banks sell government bonds to Gristly, which pays with a check drawn on the Wahoo bank. ( b) The Federal Reserve Banks clear this check against the Wahoo bank by reducing Wahoo s reserves. ( c) The Wahoo bank returns the canceled check to Gristly, reducing Gristly s checkable deposit accordingly. Federal Reserve bond sales of $1000 to the commercial banking system reduce the system s actual and excess reserves by $1000. But a $1000 bond sale to the public reduces excess reserves by $800 because the public s checkable-deposit money is also reduced by $1000 by the sale. Since the commercial banking system s outstanding checkable deposits are reduced by $1000, banks need keep $200 less in reserves. Whether the Fed sells bonds to the public or to commercial banks, the result is the same: When Federal Reserve Banks sell securities in the open market, commercial bank reserves are reduced. If all excess reserves are already lent out, this decline in commercial bank reserves produces a decline in the nation s money supply. In our example, a $1000 sale of government securities results in a $5000 decline in the money supply whether the sale is made to commercial banks or to the general public. You can verify this by reexamining Figure 33.2 and tracing the effects of a sale of a $1000 bond by the Fed either to commercial banks or to the public. What makes commercial banks and the public willing to sell government securities to, or buy them from, Federal Reserve Banks? The answer lies in the price of bonds and their interest yields. We know that bond prices and interest rates are inversely related. When the Fed buys government bonds, the demand for them increases. Government bond prices rise, and their interest yields decline. The higher bond prices and their lower interest yields prompt banks, securities firms, and individual holders of government bonds to sell them to the Federal Reserve Banks. When the Fed sells government bonds, the additional supply of bonds in the bond market lowers bond prices and raises their interest yields, making government bonds attractive purchases for banks and the public. The Reserve Ratio The Fed also can manipulate the reserve ratio in order to influence the ability of commercial banks to lend. Suppose a commercial bank s balance sheet shows that reserves are $5000 and checkable deposits are $20,000. If the legal reserve ratio is 20 percent (row 2, Table 33.2 ), the bank s required reserves are $4000. Since actual reserves are $5000, the excess reserves of this bank are $1000. On the basis of $1000 of excess reserves, this one bank can lend $1000; however, the banking system as a whole can create a maximum of $5000 of new checkable-deposit money by lending (column 7). Raising the Reserve Ratio Now, what if the Fed raised the reserve ratio from 20 to 25 percent? (See row 3.) Required reserves would jump from $4000 to $5000, shrinking excess reserves from $1000 to zero. Raising the reserve ratio increases the amount of required reserves banks must keep. As a consequence, either banks lose excess reserves, diminishing their ability to create money by lending, or they find their reserves deficient and are forced to contract checkable deposits and therefore the money supply. In the

9 668 PART EIGHT Money, Banking, and Monetary Policy TABLE 33.2 The Effects of Changes in the Reserve Ratio on the Lending Ability of Commercial Banks (5) (6) (7) (1) (2) (3) (4) Excess Money-Creating Money-Creating Reserve Checkable Actual Required Reserves, Potential of Potential of Ratio, % Deposits Reserves Reserves (3) (4) Single Bank, (5) Banking System (1) 10 $20,000 $5000 $2000 $ 3000 $ 3000 $30,000 (2) 20 20, (3) 25 20, (4) 30 20, example in Table 33.2, excess reserves are transformed into required reserves, and the money-creating potential of our single bank is reduced from $1000 to zero (column 6). Moreover, the banking system s money- creating capacity declines from $5000 to zero (column 7). What if the Fed increases the reserve requirement to 30 percent? (See row 4.) The commercial bank, to protect itself against the prospect of failing to meet this requirement, would be forced to lower its checkable deposits and at the same time increase its reserves. To reduce its checkable deposits, the bank could let outstanding loans mature and be repaid without extending new credit. To increase reserves, the bank might sell some of its bonds, adding the proceeds to its reserves. Both actions would reduce the supply of money. Lowering the Reserve Ratio What would happen if the Fed lowered the reserve ratio from the original 20 percent to 10 percent? (See row 1.) In this case, required reserves would decline from $4000 to $2000, and excess reserves would jump from $1000 to $3000. The single bank s lending (money-creating) ability would increase from $1000 to $3000 (column 6), and the banking system s money-creating potential would expand from $5000 to $30,000 (column 7). Lowering the reserve ratio transforms required reserves into excess reserves and enhances the ability of banks to create new money by lending. The examples in Table 33.2 show that a change in the reserve ratio affects the money-creating ability of the banking system in two ways: It changes the amount of excess reserves. It changes the size of the monetary multiplier. For example, when the legal reserve ratio is raised from 10 to 20 percent, excess reserves are reduced from $3000 to $1000 and the checkable-deposit multiplier is reduced from 10 to 5. The money-creating potential of the banking system declines from $30,000 ( $ ) to $5000 ( $1000 5). Raising the reserve ratio forces banks to reduce the amount of checkable deposits they create through lending. The Discount Rate One of the functions of a central bank is to be a lender of last resort. Occasionally, commercial banks have unexpected and immediate needs for additional funds. In such cases, each Federal Reserve Bank will make short-term loans to commercial banks in its district. When a commercial bank borrows, it gives the Federal Reserve Bank a promissory note (IOU) drawn against itself and secured by acceptable collateral typically U.S. government securities. Just as commercial banks charge interest on the loans they make to their clients, so too Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest rate they charge is called the discount rate. As a claim against the commercial bank, the borrowing bank s promissory note is an asset to the lending Federal Reserve Bank and appears on its balance sheet as Loans to commercial banks. To the commercial bank the IOU is a liability, appearing as Loans from the Federal Reserve Banks on the commercial bank s balance sheet. [See the two (a) entries on the balance sheets below.] Assets Commercial Bank Borrowing from the Fed Federal Reserve Banks Liabilities and net worth Loans to commercial banks (a) IOUs Assets Reserves (b) Commercial Banks Reserves of commercial banks (b) Reserves Liabilities and net worth Loans from the Federal Reserve Banks (a)

10 CHAPTER 33 Interest Rates and Monetary Policy 669 In providing the loan, the Federal Reserve Bank increases the reserves of the borrowing commercial bank. Since no required reserves need be kept against loans from Federal Reserve Banks, all new reserves acquired by borrowing from Federal Reserve Banks are excess reserves. [These changes are reflected in the two (b) entries on the balance sheets.] In short, borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit. The Fed has the power to set the discount rate at which commercial banks borrow from Federal Reserve Banks. From the commercial banks point of view, the discount rate is a cost of acquiring reserves. A lowering of the discount rate encourages commercial banks to obtain additional reserves by borrowing from Federal Reserve Banks. When the commercial banks lend new reserves, the money supply increases. An increase in the discount rate discourages commercial banks from obtaining additional reserves through borrowing from the Federal Reserve Banks. So the Fed may raise the discount rate when it wants to restrict the money supply. (Key Question 5) Term Auction Facility The fourth Fed tool for altering bank reserves is its term auction facility. This tool was introduced in December 2007 in response to the mortgage debt crisis, in which tens of thousands of homeowners defaulted on mortgage loans when they experienced higher mortgage interest rates and falling home prices. (We discuss this financial mess in detail in this chapter s Last Word.) Under the term auction facility, the Fed holds two auctions each month at which banks bid for the right to borrow reserves for 28-day periods. For instance, the Fed might auction off $20 billion in reserves. Banks that want to participate in the auction submit bids that include two pieces of information: how much they wish to borrow and the interest rate that they would be willing to pay. As an example, Wahoo bank might want to borrow $1 billion and offer to pay an annual interest rate of 4.35 percent. These bids are submitted secretly. Once they are received, Fed officials arrange them from highest to lowest by interest rate. The limited pool of $20 billion goes to those banks that offer to pay the highest interest rates for the money that they desire to borrow. But the rate that all the auction winners actually pay is the same it is the rate offered by the lowest bidder whose bid is accepted. For instance, suppose that 56 banks submit bids that total $36 billion. The Fed sorts these from highest to lowest based upon interest rates and then goes down the list to see how many banks can get their desired loan amounts before exhausting the $20 billion. Suppose that the top 23 banks together wish to borrow $18 billion and that the 24th bank wishes to borrow the remaining $2 billion. Since its request would exhaust the $20 billion that is being auctioned off, its interest rate is the one that all 24 of the auction-winning banks will have to pay. Lending through the term auction facility guarantees that the amount of reserves that the Fed wishes to lend will be borrowed. This is true because the auction procedure for determining the interest rate on the loans serves to produce an equilibrium price (interest rate) at which the quantity demanded of loans exactly equals the quantity supplied of loans (the amount of reserves that the Fed is auctioning off). The Fed finds this to be very helpful when it wants to increase reserves by a specific amount because it can be sure that those reserves will, in fact, be borrowed, thereby increasing the overall level of reserves in the banking system. In contrast, lowering the discount rate may or may not produce the exact level of borrowing the Fed desires. It was this very positive aspect of the term auction facility that caused the Fed to start using it in late 2007 when it wished to increase bank reserves during the mortgage debt crisis. Reserves fell dramatically during that crisis and the Fed wanted to be sure to increase reserves so that banks would have excess reserves and therefore the ability to keep making loans. In terms of balance sheets, however, loans of reserves borrowed by auction-winning banks under the term auction facility work exactly the same as loans of reserves taken out by banks when they are borrowing at the discount rate. Commercial banks send IOUs to the Fed and the Fed sends reserves to the commercial banks. As a result, the Fed can modulate the money supply by increasing or decreasing the amount of reserves that it auctions off every two weeks under the term auction facility. Relative Importance All four of the Fed s instruments of monetary control are useful in particular economic circumstances, but openmarket operations are clearly the most important of the four tools over the course of the business cycle. The buying and selling of securities in the open market has the advantage of flexibility government securities can be purchased or sold daily in large or small amounts and the impact on bank reserves is prompt. And, compared with reserverequirement changes, open-market operations work subtly and less directly. Furthermore, the ability of the Federal Reserve Banks to affect commercial bank reserves through the purchase and sale of bonds is virtually unquestionable.

11 670 PART EIGHT Money, Banking, and Monetary Policy The Federal Reserve Banks have very large holdings of government securities ($730 billion in early 2008 for example). The sale of those securities could theoretically reduce commercial bank reserves to zero. Changing the reserve requirement is a potentially powerful instrument of monetary control, but the Fed has used this technique only sparingly. Normally, it can accomplish its monetary goals more easily through open-market operations. The limited use of changes in the reserve ratio undoubtedly relates to the fact that reserves earn no interest. Indeed, when the Fed raises or lowers the reserve ratio, it has a substantial effect on bank profits because it implicitly changes the amount of money on which banks are forced to earn a zero percent rate of return. The last change in the reserve requirement was in 1992, when the Fed reduced the requirement from 12 percent to 10 percent. The main purpose was to shore up the profitability of banks and thrifts in the aftermath of the recession rather than to reduce interest rates by increasing reserves and expanding the money supply. Until recently, the discount rate was mainly a passive tool of monetary control, with the Fed raising and lowering the rate simply to keep it in line with other interest rates. However, during the mortgage debt crisis, the Fed aggressively lowered the discount rate independently of other interest rates in order to provide a cheap and plentiful source of reserves to banks whose reserves were being sharply reduced by unexpectedly high default rates on home mortgage loans. Banks borrowed billions at the lower discount rate. This allowed them to meet reserve ratio requirements and thereby preserved their ability to keep extending loans. As the mortgage debt crisis grew more severe, however, the Fed found that banks became increasingly reluctant to borrow at the discount rate for fear that such borrowing would be interpreted by their own lenders and stockholders as a sign of being in deep financial trouble. This prompted the Fed to create the term auction facility and, perhaps more importantly, to make it anonymous. When the Fed holds an auction of reserves using the term auction facility, banks submit their bids anonymously and auction winners are given their loans anonymously. This anonymity ensures that banks will participate in the auctions since they do not have to worry about being suspected of being in a financially weak condition. The success of the term auction facility has led the Fed to adopt the auction of reserves as a fourth permanent tool of monetary policy. That being said, most economists believe that it will probably only be used during times of crisis when the Fed believes that the banking system can be helped by a large, quick injection of reserves. QUICK REVIEW 33.2 The Fed has four main tools of monetary control, each of which works by changing the amount of reserves in the banking system: (a) conducting open-market operations (the Fed s buying and selling of government bonds to the banks and the public); (b) changing the reserve ratio (the percentage of commercial bank deposit liabilities required as reserves); (c) changing the discount rate (the interest rate the Federal Reserve Banks charge on loans to banks and thrifts); and (d) auctioning off reserves to banks using the term auction facility. Open-market operations are the Fed s monetary control mechanism of choice for routine increases or decreases in bank reserves over the business cycle; in contrast, changes in reserve requirements, aggressive changes in discount rates, and auctions of reserves are used only in special situations. Targeting the Federal Funds Rate The Federal Reserve focuses monetary policy on the interest rate that it can best control: the Federal funds rate. From the previous chapter, you know that this is the rate of interest that banks charge one another on overnight loans made from temporary excess reserves. Recall that the Federal Reserve requires banks (and thrifts) to deposit in their regional Federal Reserve Bank a certain percentage of their checkable deposits as reserves. At the end of any business day, some banks temporarily have excess reserves (more actual reserves than required) and other banks have reserve deficiencies (fewer reserves than required). Because reserves held at the Federal Reserve Banks do not earn interest, banks with excess reserves desire to lend out their temporary excess reserves overnight to other banks that temporarily need them to meet their reserve requirements. The funds being lent and borrowed overnight are called Federal funds because they are reserves (funds) that are required by the Federal Reserve to meet reserve requirements. An equilibrium interest rate the Federal funds rate arises in this market for bank reserves. The Federal Reserve targets the Federal funds rate by manipulating the supply of reserves that are offered in the Federal funds market. As previously explained, by buying and selling government bonds, the Fed can increase or decrease the reserves in the banking system. These changes in total reserves in turn affect the amount of excess reserves that are available for supply to the Federal funds market by whichever banks end up with them on a given day. For instance, suppose that the level of loans and checkable

12 CHAPTER 33 Interest Rates and Monetary Policy 671 deposits at Wahoo bank are constant on a certain day. If the Fed then engages in open-market operations such that Wahoo s total reserves increase, Wahoo will find that it has excess reserves. It will want to loan out these excess reserves to bank customers as soon as possible. But in the meanwhile it will supply these funds overnight in the Federal funds market. The Federal Open Market Committee (FOMC) meets regularly to choose a desired Federal funds rate. It then directs the Federal Reserve Bank of New York to undertake whatever open-market operations may be necessary to achieve and maintain the targeted rate. We demonstrate how this works in Figure 33.3, where we initially assume the Fed desires a 4 percent interest rate. The demand curve for Federal funds, D f, is downsloping because lower interest rates give the banks with reserve deficiencies a greater incentive to borrow Federal funds rather than reduce loans as a way to meet their reserve requirements. The supply curve for Federal funds, S f 1, is somewhat unusual. Specifically, it is horizontal at the targeted Federal funds rate, here 4 percent. (Disregard supply curves S f 2 and S f 3 for now.) It is horizontal because the Fed uses open-market operations to manipulate the supply of Federal funds so that the quantity supplied of Federal funds will exactly FIGURE 33.3 Targeting the Federal funds rate In implementing monetary policy, the Federal Reserve determines a desired Federal funds rate and then uses open-market operations (buying and selling of U.S. securities) to add or subtract bank reserves to achieve and maintain that targeted rate. In an expansionary monetary policy, the Fed increases the supply of reserves, for example, from S f 1 to S f 2 in this case, to move the Federal funds rate from 4 percent to 3.5 percent. In a restrictive monetary policy, it decreases the supply of reserves, say, from S f 1 to S f 3. Here, the Federal funds rate rises from 4 percent to 4.5 percent. Federal funds rate (percent) Q f 3 Q f1 Q f 2 Quantity of reserves S f 3 S f1 S f 2 D f equal the quantity demanded of Federal funds at the targeted interest rate. In this case, the Fed seeks to achieve an equilibrium Federal funds rate of 4 percent. In Figure 33.3 it is successful. Note that at the 4 percent Federal funds rate, the quantity of Federal funds supplied (QQ f1 ) equals the quantity of funds demanded (also Q f 1 ). This 4 percent Federal funds rate will remain, as long as the supply curve of Federal funds is horizontal at 4 percent. If the demand for Federal funds increases ( D f shifts to the right along S f1 ), the Fed will use its open-market operations to increase the availability of reserves such that the 4 percent Federal funds rate is retained. If the demand for Federal funds declines ( D f shifts to the left along S f 1 ), the Fed will withdraw reserves to keep the Federal funds rate at 4 percent. Expansionary Monetary Policy Suppose that the economy faces recession and unemployment. How will the Fed respond? It will initiate an expansionary monetary policy (or easy money policy ). This policy will lower the interest rate to bolster borrowing and spending, which will increase aggregate demand and expand real output. The Fed s immediate step will be to announce a lower target for the Federal funds rate, say 3.5 percent instead of 4 percent. To achieve that lower rate, the Fed will use open-market operations to buy bonds from banks and the public. We know from previous discussion that the purchase of bonds increases the reserves in the banking system. Alternatively, the Fed could expand reserves by lowering the reserve requirement, lowering the discount rate, or auctioning off more reseves, but these alternative tools are less frequently used than open-market operations. The greater reserves in the banking system produce two critical results: The supply of Federal funds increases, lowering the Federal funds rate to the new targeted rate. We show this in Figure 33.3 as a downward shift to the horizontal supply curve from S f 1 to S f2. The equilibrium Federal funds rate falls to 3.5 percent, just as the FOMC wanted. The equilibrium quantity of reserves in the overnight market for reserves rises from Q f 1 to Q f 2. A multiple expansion of the nation s money supply occurs (as we demonstrated in Chapter 32). Given the demand for money, the larger money supply places a downward pressure on other interest rates. One such rate is the prime interest rate the benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to businesses and individuals. The prime interest rate is higher than the

13 672 PART EIGHT Money, Banking, and Monetary Policy FIGURE 33.4 The prime interest rate and the Federal funds rate in the United States, The prime interest rate rises and falls with changes in the Federal funds rate Prime interest rate Percent 4 Federal funds rate Year Federal funds rate because the prime rate involves longer, more risky loans than overnight loans between banks. But the Federal funds rate and the prime interest rate closely track one another, as evident in Figure Restrictive Monetary Policy The opposite monetary policy is in order for periods of rising inflation. The Fed will then undertake a restrictive monetary policy (or tight money policy ). This policy will increase the interest rate in order to reduce borrowing and spending, which will curtail the expansion of aggregate demand and hold down price-level increases. The Fed s immediate step will be to announce a higher target for the Federal funds rate, say 4.5 percent instead of 4 percent. Through open-market operations, the Fed will sell bonds to the banks and the public and the sale of those bonds will absorb reserves in the banking system. Alternatively, the Fed could absorb reserves by raising the reserve requirement, raising the discount rate, or reducing the amount of reserves that it auctions off. But, open-market operations are usually sufficient to accomplish the goal. The smaller reserves in the banking system produce two results opposite those discussed for an expansionary monetary policy: The supply of Federal funds decreases, raising the Federal funds rate to the new targeted rate. We show this in Figure 33.3 as an upward shift of the horizonal supply curve from S f1 to S f 3. The equilibrium Federal funds rate rises to 4.5 percent, just as the FOMC wanted, and the equilibrium quantity of funds in this market falls to Q f 3. A multiple contraction of the nation s money supply occurs (as demonstrated in Chapter 32). Given the demand for money, the smaller money supply places an upward pressure on other interest rates. For example, the prime interest rate rises. The Taylor Rule The proper Federal funds rate for a certain period is a matter of policy discretion by the members of the FOMC. At each of their meetings, committee members assess whether the current target for the Federal funds rate remains appropriate for achieving the twin goals of low inflation and full employment. If the majority of the FOMC members conclude that a change in the rate is needed, the FOMC sets a new targeted rate. This new target is established without adhering to any particular inflationary target or monetary policy rule. Instead, the committee targets the

14 CHAPTER 33 Interest Rates and Monetary Policy 673 CONSIDER THIS... The Fed as a Sponge A good way to remember the role of the Fed in setting the Federal funds rate might be to imagine a bowl of water, with the amount of water in the bowl representing the stock of reserves in the banking system. Then think of the FOMC as having a large sponge, labeled open-market operations. When it wants to decrease the Federal funds rate, it uses the sponge soaked with water (reserves) created by the Fed to squeeze new reserves into the banking system bowl. It continues this process until the higher supply of reserves reduces the Federal funds rate to the Fed s desired level. If the Fed wants to increase the Federal funds rate, it uses the sponge to absorb reserves from the bowl (banking system). As the supply of reserves falls, the Federal funds rate rises to the Fed s desired level. 1.5 percentage point increase in the nominal rate in order to account for the underlying 1 percent increase in the inflation rate.) The last two rules are applied independently of each other so that if real GDP is above potential output and at the same time inflation is above the 2 percent target rate, the Fed will apply both rules and raise real interest rates in response to both factors. For instance, if real GDP is 1 percent above potential output and inflation is simultaneously 1 percent above the 2 percent target rate, then the Fed will raise the real Federal funds rate by 1 percentage point ( ½ percentage point for the excessive GDP ½ percentage point for the excessive inflation). Also notice that the last two rules are reversed for situations in which real GDP falls below potential GDP or inflation falls below 2 percent. Each 1 percent decline in real GDP below potential GDP or fall in inflation below 2 percent calls for a decline of the real Federal funds rate by ½ percentage point. We reemphasize that the Fed has no official allegiance to ORIGIN OF THE IDEA O 33.4 Taylor rule the Taylor rule. It changes the Federal funds rate to any level that it deems appropriate. Federal funds rate at the level most appropriate for the current underlying economic conditions. A rule of thumb suggested by economist John Taylor of Stanford roughly tracks the actual policy of the Fed. This rule of thumb builds on the belief held by many economists that central banks are willing to tolerate a small positive rate of inflation if doing so will help the economy to produce at potential output. The Taylor rule assumes that the Fed has a 2 percent target rate of inflation that it is willing to tolerate and that the FOMC follows three rules when setting its target for the Federal funds rate: When real GDP equals potential GDP and inflation is at its target rate of 2 percent, the Federal funds target rate should be 4 percent, implying a real Federal funds rate of 2 percent ( 4 percent nominal Federal funds rate 2 percent inflation rate). For each 1 percent increase of real GDP above potential GDP, the Fed should raise the real Federal funds rate by ½ percentage point. For each 1 percent increase in the inflation rate above its 2 percent target rate, the Fed should raise the real Federal funds rate by ½ percentage point. (Note, though, that in this case each ½ percentage point increase in the real rate will require a QUICK REVIEW 33.3 The Fed conducts its monetary policy by establishing a targeted Federal funds interest rate the rate that commercial banks charge one another for overnight loans of reserves. An expansionary monetary policy (loose money policy) lowers the Federal funds rate, increases the money supply, and lowers other interest rates. A restrictive monetary policy (tight money policy) increases the Federal funds rate, reduces the money supply, and increases other interest rates. The Fed uses it discretion in setting the Federal funds target rate, but its decisions regarding monetary policy and the target rate appear to be broadly consistent with the Taylor rule. Monetary Policy, Real GDP, and the Price Level We have identified and explained the tools of expansionary and contractionary monetary policy. We now want to emphasize how monetary INTERACTIVE GRAPHS G 33.2 Monetary policy policy affects the economy s levels of investment, aggregate demand, real GDP, and prices.

15 keygraph FIGURE 33.5 Monetary policy and equilibrium GDP. An expansionary monetary policy that shifts the money supply curve rightward from S m1 to S m2 in (a) lowers the interest rate from 10 to 8 percent in (b). As a result, investment spending increases from $15 billion to $20 billion, shifting the aggregate demand curve rightward from AD 1 to AD 2 in (c) so that real output rises from the recessionary level of $880 billion to the fullemployment level Q f $900 billion along the horizontal dashed segment of aggregate supply. In (d), the economy at point a has an inflationary output gap of $10 billion because it is producing at $910 billion, $10 billion above potential output. A restrictive monetary policy that shifts the money supply curve leftward from Sm 3 $175 billion to just $162.5 billion in (a) will increase the interest rate from 6 to 7 percent. Investment spending thus falls by $2.5 billion from $25 billion to $22.5 billion in (b). This initial decline is multiplied by 4 by the multiplier process so that the aggregate demand curve shifts leftward in (d) by $10 billion from AD 3 to AD 4, moving the economy along the horizontal dashed segment of aggregate supply to equilibrium b. This returns the economy to full employment and eliminates the inflationary output gap. S m1 S m2 S m3 Real rate of interest, i (percent) 10 8 Real rate of interest, i and expected rate of return (percent) 10 8 Investment demand 6 6 D m ID 0 $125 $150 $175 Amount of money demanded and supplied (billions of dollars) (a) The market for money 0 $15 $20 $25 Amount of investment, I (billions of dollars) (b) Investment demand QUICK QUIZ FOR FIGURE The ultimate objective of an expansionary monetary policy is depicted by: a. a decrease in the money supply from S m3 to S m2. b. a reduction of the interest rate from 8 to 6 percent. c. an increase in investment from $20 billion to $25 billion. d. an increase in real GDP from Q 1 to Q f. Cause-Effect Chain The four diagrams in Figure 33.5 (Key Graph) will help you understand how monetary policy works toward achieving its goals. Market for Money Figure 33.5 a represents the market for money, in which the demand curve for money and the supply curve of money are brought together. Recall that the total demand for money is made up of the transactions and asset demands. This figure also shows three potential money supply curves, S m1, S m2, and S m3. In each case, the money supply is shown as a vertical line representing some fixed amount of money determined by the Fed. The equilibrium interest rate is the rate at which the amount of money demanded and the amount supplied are equal. With money demand D m in Figure 33.5 a, if the supply of money is $125 billion ( S m1 ), the equilibrium interest rate is 10 percent. With a money supply of $150 billion ( S m 2 ), the equilibrium interest rate is 8 percent; with a money supply of $175 billion (S m3 ), it is 6 percent. 674

16 AS AS Price level P 3 P 2 AD 3 (I = $25) Price level P 3 P 2 c b a AD 3 (I = $25) AD 4 (I = $22.5) AD 2 (I = $20) AD 2 (I = $20) AD 1 (I = $15) AD 1 (I = $15) 0 $880 $ $910 Real domestic product, GDP (billions of dollars) (c) Equilibrium real GDP and the price level 0 $880 Q f $ $910 Real domestic product, GDP (billions of dollars) (d) Equilibrium real GDP and the price level 2. A successful restrictive monetary policy is evidenced by a shift in the money supply curve from: a. S m3 to a point half way between S m2 and S m3, a decrease in investment from $25 billion to $22.5 billion, and a decline in aggregate demand from AD 3 to AD 4. b. S m1 to S m2, an increase in investment from $20 billion to $25 billion, and an increase in real GDP from Q 1 to Q f. c. S m3 to S m2, a decrease in investment from $25 billion to $20 billion, and a decline in the price level from P 3 to P 2. d. S m3 to S m2, a decrease in investment from $25 billion to $20 billion, and an increase in aggregate demand from AD 2 to AD The Federal Reserve could increase the money supply from S m1 to S m2 by: a. increasing the discount rate. b. reducing taxes. c. buying government securities in the open market. d. increasing the reserve requirement. 4. If the spending-income multiplier is 4 in the economy depicted, an increase in the money supply from $125 billion to $150 billion will: a. shift the aggregate demand curve rightward by $20 billion. b. increase real GDP by $25 billion. c. increase real GDP by $100 billion. d. shift the aggregate demand curve leftward by $5 billion. Answers:1. d; 2. c; 3. c; 4. a You know from Chapter 27 that the real, not the nominal, rate of interest is critical for investment decisions. So here we assume that Figure 33.5a portrays real interest rates. Investment These 10, 8, and 6 percent real interest rates are carried rightward to the investment demand curve in Figure 33.5 b. This curve shows the inverse relationship between the interest rate the cost of borrowing to invest and the amount of investment spending. At the 10 percent interest rate, it will be profitable for the nation s businesses to invest $15 billion; at 8 percent, $20 billion; at 6 percent, $25 billion. Changes in the interest rate mainly affect the investment component of total spending, although they also affect spending on durable consumer goods (such as autos) that are purchased on credit. The impact of changing interest rates on investment spending is great because of the large cost and long-term nature of capital purchases. Capital equipment, factory buildings, and warehouses are tremendously expensive. In absolute terms, interest charges on funds borrowed for these purchases are considerable. 675

17 676 PART EIGHT Money, Banking, and Monetary Policy Similarly, the interest cost on a house purchased on a long-term contract is very large: A 1 2 -percentage-point change in the interest rate could amount to thousands of dollars in the total cost of buying a home. In brief, the impact of changing interest rates is mainly on investment (and, through that, on aggregate demand, output, employment, and the price level). Moreover, as Figure 33.5 b shows, investment spending varies inversely with the real interest rate. Equilibrium GDP Figure 33.5 c shows the impact of our three real interest rates and corresponding levels of investment spending on aggregate demand. (Ignore Figure 33.5d for the time being. We will return to it shortly.) As noted, aggregate demand curve AD 1 is associated with the $15 billion level of investment, AD 2 with investment of $20 billion, and AD 3 with investment of $25 billion. That is, investment spending is one of the determinants of aggregate demand. Other things equal, the greater the investment spending, the farther to the right lies the aggregate demand curve. Suppose the money supply in Figure 33.5 a is $150 billion ( S m2 ), producing an equilibrium interest rate of 8 percent. In Figure 33.5 b we see that this 8 percent interest rate will bring forth $20 billion of investment spending. This $20 billion of investment spending joins with consumption spending, net exports, and government spending to yield aggregate demand curve AD 2 in Figure 33.5 c. The equilibrium levels of real output and prices are Q f $900 billion and P 2, as determined by the intersection of AD 2 and the aggregate supply curve AS. To test your understanding of these relationships, explain why each of the other two levels of money supply in Figure 33.5a results in a different interest rate, level of investment, aggregate demand curve, and equilibrium real output. Effects of an Expansionary Monetary Policy Recall that the inflationary ratchet effect discussed in Chapter 29 describes the fact that real-world price levels tend to be downwardly inflexible. Thus, with our economy starting from the initial equilibrium where AD 2 intersects AS, the price level will be downwardly inflexible at P 2 so that aggregate supply will be horizontal to the left of Q f. This means that if aggregate demand decreases, the economy s equilibrium will move leftward along the dashed horizontal line shown in Figure 33.5c. Just such a decline would happen if the money supply fell to $125 billion (S m1 ), shifting the aggregate demand curve leftward to AD 1 in Figure 33.5c. This results in a real output of $880 billion, $20 billion less than the economy s full-employment output level of $900 billion. The economy will be experiencing recession, a negative GDP gap, and substantial unemployment. The Fed therefore should institute an expansionary monetary policy. To increase the money supply, the Fed will take some combination of the following actions: (1) buy government securities from banks and the public in the open market, (2) lower the legal reserve ratio, (3) lower the discount rate, and (4) increase reserve auctions. The intended outcome will be an increase in excess reserves in the commercial banking system and a decline in the Federal funds rate. Because excess reserves are the basis on which commercial banks and thrifts can earn profit by lending and thus creating checkable-deposit money, the nation s money supply will rise. An increase in the money supply will lower the interest rate, increasing investment, aggregate demand, and equilibrium GDP. For example, an increase in the money supply from $125 billion to $150 billion (SS m1 to S m2 ) will reduce the interest rate from 10 to 8 percent, as indicated in Figure 33.5a, and will boost investment from $15 billion to $20 billion, as shown in Figure 33.5b. This $5 billion increase in investment will shift the aggregate demand curve rightward by more than the increase in investment because of the multiplier effect. If the economy s MPC is.75, the multiplier will be 4, meaning that the $5 billion increase in investment will shift the AD curve rightward by $20 billion ( 4 $5 billion) at each price level. Specifically, aggregate demand will shift from AD 1 to AD 2, as shown in Figure 33.5c. This rightward shift in the aggregate demand curve along the dashed horizontal part of aggregate supply will eliminate the negative GDP gap by increasing GDP from $880 billion to the full-employment GDP of Q f $900 billion. 1 Column 1 in Table 33.3 summarizes the chain of events associated with an expansionary monetary policy. Effects of a Restrictive Monetary Policy To prevent Figure 33.5c from getting too crowded as we consider restrictive monetary policy, we will combine the money market in Figure 33.5a and the investment demand 1 To keep things simple, we assume that the increase in real GDP does not increase the demand for money. In reality, the transactions demand for money would rise, slightly dampening the decline in the interest rate shown in Figure 33.5a.

18 CHAPTER 33 Interest Rates and Monetary Policy 677 TABLE 33.3 Monetary Policies for Recession and Inflation (1) (2) Expansionary Restrictive Monetary Policy Monetary Policy Problem: unemployment and recession Federal Reserve buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises Problem: infl ation Federal Reserve sells bonds, increases reserve ratio, raises the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Infl ation declines curve of Figure 33.5b that we have already been using with the aggregate demand and aggregate supply curves shown in Figure 33.5d. Figure 33.5d represents exactly the same economy as Figure 33.5c but adds some extra curves that relate only to our explanation of restrictive monetary policy. To see how restrictive monetary policy works, let us first consider a situation in which the economy moves from a full-employment equilibrium to operating at more than full employment so that inflation is a problem and restrictive monetary policy would be appropriate. Assume that the economy begins at the full-employment equilibrium where AD 2 and AS intersect. At this equilibrium, Q f $900 billion and the price level is P 2. Next, assume that the money supply grows to $175 billion (S m3 ) in Figure 33.5a. This results in an interest rate of 6 percent, investment spending of $25 billion, and aggregate demand AD 3. As the AD curve shifts to the right from AD 2 to AD 3 in Figure 33.5d, the economy will move along the upwardsloping AS curve until it comes to an equilibrium at point a, where AD 3 intersects AS. At the new equilibrium, the price level has risen to P 3 and the equilibrium level of real GDP has risen to $910 billion, indicating an inflationary GDP gap of $10 billion ( $910 billion $900 billion). Aggregate demand AD 3 is excessive relative to the economy s full-employment level of real output Q f $900 billion. To rein in spending, the Fed will institute a restrictive monetary policy. The Federal Reserve Board will direct Federal Reserve Banks to undertake some combination of the following actions: (1) sell government securities to banks and the public in the open market, (2) increase the legal reserve ratio, (3) increase the discount rate, and (4) decrease the amount of reserves auctioned off under the term auction facility. Banks then will discover that their reserves are below those required and that the Federal funds rate has increased. So they will need to reduce their checkable deposits by refraining from issuing new loans as old loans are paid back. This will shrink the money supply and increase the interest rate. The higher interest rate will discourage investment, lowering aggregate demand and restraining demand-pull inflation. But the Fed must be careful about just how much to decrease the money supply. The problem is that the inflation ratchet will take effect at the new equilibrium point a, such that prices will be inflexible at price level P 3. As a result, aggregate supply to the left of point a will be the horizontal dashed line shown in Figure 33.5d. This means that the Fed cannot simply lower the money supply to S m2 in Figure 33.5a. If it were to do that, investment demand would fall to $20 billion in Figure 33.5b and the AD curve would shift to the left from AD 3 back to AD 2. But because of inflexible prices, the economy s equilibrium would move to point c, where AD 2 intersects the horizontal dashed line that represents aggregate supply to the left of point a. This would put the economy into a recession, with equilibrium output below the full-employment output level of Q f $900 billion. What the Fed needs to do to achieve full employment is to move the AD curve back only from AD 2 to AD 4, so that the economy will come to equilibrium at point b. This will require a $10 billion decrease in aggregate demand, so that equilibrium output falls from $910 billion at point a to Q f $900 billion at point b. The Fed can achieve this shift by setting the supply of money in Figure 33.5a at $162.5 billion. To see how this works, draw in a vertical money supply curve in Figure 33.5a at $162.5 billion and label it as S m4. It will be exactly

19 678 PART EIGHT Money, Banking, and Monetary Policy halfway between money supply curves S m2 and S m3. Notice that the intersection of S m4 with the money demand curve D m will result in an interest rate of 7 percent. In Figure 33.5b, this interest rate of 7 percent will result in investment spending of $22.5 billion (halfway between $20 billion and $25 billion). Thus, by setting the money supply at $162.5 billion, the Fed can reduce investment spending by $2.5 billion, lowering it from the $25 billion associated with AD 3 down to only $22.5 billion. This decline in investment spending will initially shift the AD curve only $2.5 billion to the left of AD 3. But then the multiplier process will work its magic. Since the multiplier is 4 in our model, the AD curve will end up moving by a full $10 billion ( 4 $2.5 billion) to the left, to AD 4. This shift will move the economy to equilibrium b, returning output to the full employment level and eliminating the inflationary GDP gap. 2 Column 2 in Table 33.3 summarizes the cause-effect chain of a tight money policy. Monetary Policy: Evaluation and Issues Monetary policy has become the dominant component of U.S. national stabilization policy. It has two key advantages over fiscal policy: Speed and flexibility. Isolation from political pressure. Compared with fiscal policy, monetary policy can be quickly altered. Recall that congressional deliberations may delay the application of fiscal policy for months. In contrast, the Fed can buy or sell securities from day to day and thus affect the money supply and interest rates almost immediately. Also, because members of the Fed s Board of Governors are appointed and serve 14-year terms, they are relatively isolated from lobbying and need not worry about retaining their popularity with voters. Thus, the Board, more readily than Congress, can engage in politically unpopular policies (higher interest rates) that may be necessary for the long-term health of the economy. Moreover, monetary policy is a subtler and more politically conservative measure than fiscal policy. Changes 2 Again, we assume for simplicity that the decrease in nominal GDP does not feed back to reduce the demand for money and thus the interest rate. In reality, this would occur, slightly dampening the increase in the interest rate show in Figure 33.5a. in government spending directly affect the allocation of resources, and changes in taxes can have extensive political ramifications. Because monetary policy works more subtly, it is more politically palatable. Recent U.S. Monetary Policy In the early 1990s, the Fed s expansionary monetary policy helped the economy recover from the recession. The expansion of GDP that began in 1992 continued through the rest of the decade. By 2000 the U.S. unemployment rate had declined to 4 percent the lowest rate in 30 years. To counter potential inflation during that strong expansion, in 1994 and 1995, and then again in early 1997, the Fed reduced reserves in the banking system to raise the interest rate. In 1998 the Fed temporarily reversed its course and moved to a more expansionary monetary policy to make sure that the U.S. banking system had plenty of liquidity in the face of a severe financial crisis in southeast Asia. The economy continued to expand briskly, and in 1999 and 2000 the Fed, in a series of steps, boosted interest rates to make sure that inflation remained under control. Significant inflation did not occur in the late 1990s. But in the last quarter of 2000 the economy abruptly slowed. The Fed responded by cutting interest rates by a full percentage point in two increments in January Despite these rate cuts, the economy entered a recession in March Between March 20, 2001, and August 21, 2001, the Fed cut the Federal funds rate from 5 percent to 3.5 percent in a series of steps. In the 3 months following the terrorist attacks of September 11, 2001, it lowered the Federal funds rate from 3.5 percent to 1.75 percent, and it left the rate there until it lowered it to 1.25 percent in November Partly because of the Fed s actions, the prime interest rate dropped from 9.5 percent at the end of 2000 to 4.25 percent in December Economists generally credit the Fed s adroit use of monetary policy as one of a number of factors that helped the U.S. economy achieve and maintain the rare combination of full employment, price-level stability, and strong economic growth that occurred between 1996 and The Fed also deserves high marks for helping to keep the recession of 2001 relatively mild, particularly in view of the adverse economic impacts of the terrorist attacks of September 11, 2001, and the steep stock market drop in In 2003 the Fed left the Federal funds rate at historic lows. But as the economy began to expand robustly in 2004, the Fed engineered a gradual series of rate hikes designed

20 CHAPTER 33 Interest Rates and Monetary Policy 679 to boost the prime interest rate and other interest rates to make sure that aggregate demand continued to grow at a pace consistent with low inflation. By the summer of 2006, the target for the Federal funds rate had risen to 5.25 percent and the prime rate was 8.25 percent. With the economy enjoying robust, noninflationary growth, the Fed left the Federal funds rate at 5.25 percent for over a year until the mortgage debt crisis threatened the economy during the late summer of 2007 (see this chapter s Last Word). In response to the crisis, the Fed took several actions. In August it lowered the discount rate by half a percentage point. Then, between September 2007 and April 2008, it lowered the target for the Federal funds rate from 5.25 percent to 2 percent. The Fed also initiated the term auction facility in December 2007 and took a series of extraordinary actions to prevent the failure of key financial firms. All these monetary actions and lender-of-last resort functions helped to stabilize the banking sector and stimulate the economy thereby offsetting at least some of the damage done by the mortgage debt crisis. The Federal Reserve was lauded by many observers. Problems and Complications Despite its recent successes in the United States, monetary policy has certain limitations and faces real-world complications. Lags Recall that fiscal policy is hindered by three delays, or lags a recognition lag, an administrative lag, and an operational lag. Monetary policy also faces a recognition lag and an operational lag, but because the Fed can decide and implement policy changes within days, it avoids the long administrative lag that hinders fiscal policy. A recognition lag affects monetary policy because normal monthly variations in economic activity and the price level mean that the Fed may not be able to quickly recognize when the economy is truly starting to recede or when inflation is really starting to rise. Once the Fed acts, an operation lag of 3 to 6 months affects monetary policy because that much time is typically required for interest-rate changes to have their full impacts on investment, aggregate demand, real GDP, and the price level. These two lags complicate the timing of monetary policy. Cyclical Asymmetry Monetary policy may be highly effective in slowing expansions and controlling inflation but less reliable in pushing the economy from a severe recession. Economists say that monetary policy may suffer from cyclical asymmetry. If pursued vigorously, a restrictive monetary policy could deplete commercial banking reserves to the point where banks would be forced to reduce the volume of loans. That would mean a contraction of the money supply, higher interest rates, and reduced aggregate demand. The Fed can absorb reserves and eventually achieve its goal. But it cannot be certain of achieving its goal when it adds reserves to the banking system. An expansionary CONSIDER THIS... Pushing on a String In the late 1990s and early 2000s, the central bank of Japan used an expansionary monetary policy to reduce real interest rates to zero. Even with interest-free loans available, most consumers and businesses did not borrow and spend more. Japan s economy continued to sputter in and out of recession. The Japanese circumstance illustrates the possible asymmetry of monetary policy, which economists have likened to pulling versus pushing on a string. A string may be effective at pulling something back to a desirable spot, but it is ineffective at pushing it toward a desired location. So it is with monetary policy, say some economists. Monetary policy can readily pull the aggregate demand curve to the left, reducing demand-pull inflation. There is no limit on how much a central bank can restrict a nation s money supply and hike interest rates. Eventually, a sufficiently restrictive monetary policy will reduce aggregate demand and inflation. But during severe recession, participants in the economy may be highly pessimistic about the future. If so, an expansionary monetary policy may not be able to push the aggregate demand curve to the right, increasing real GDP. The central bank can produce excess reserves in the banking system by reducing the reserve ratio, lowering the discount rate, purchasing government securities, and increasing reserve auctions. But commercial banks may not be able to find willing borrowers for those excess reserves, no matter how low interest rates fall. Instead of borrowing and spending, consumers and businesses may be more intent on reducing debt and increasing saving in preparation for expected worse times ahead. If so, monetary policy will be ineffective. Using it under those circumstances will be much like pushing on a string.

21 keygraph FIGURE 33.6 The AD-AS theory of the price level, real output, and stabilization policy. This figure integrates the various components of macroeconomic theory and stabilization policy. Determinants that either constitute public policy or are strongly influenced by public policy are shown in red. QUICK QUIZ FOR FIGURE All else equal, an increase in domestic resource availability will: a. increase input prices, reduce aggregate supply, and increase real output. b. raise labor productivity, reduce interest rates, and lower the international value of the dollar. c. increase net exports, increase investment, and reduce aggregate demand. d. reduce input prices, increase aggregate supply, and increase real output. 2. All else equal, an expansionary monetary policy during a recession will: a. lower the interest rate, increase investment, and reduce net exports. b. lower the interest rate, increase investment, and increase aggregate demand. c. increase the interest rate, increase investment, and reduce net exports. d. reduce productivity, aggregate supply, and real output. 680

22 3. A personal income tax cut, combined with a reduction in corporate income and excise taxes, would: a. increase consumption, investment, aggregate demand, and aggregate supply. b. reduce productivity, raise input prices, and reduce aggregate supply. c. increase government spending, reduce net exports, and increase aggregate demand. d. increase the supply of money, reduce interest rates, increase investment, and expand real output. 4. An appreciation of the dollar would: a. reduce the price of imported resources, lower input prices, and increase aggregate supply. b. increase net exports and aggregate demand. c. increase aggregate supply and aggregate demand. d. reduce consumption, investment, net export spending, and government spending. 681

23 LAST Word The Mortgage Debt Crisis: The Fed Responds In 2007, Massive Defaults on Home Mortgages Threatened to Bring the Credit Markets to a Halt. The Fed Acted Quickly to Restore Confidence and Keep Loans Flowing. In 2007, a major wave of defaults on home mortgages threatened the health of any financial institution that had invested in home mortgages either directly or indirectly. A majority of these mortgage defaults were on subprime mortgage loans high-interest rate loans to home buyers with higher-than-average credit risk. Crucially, several of the biggest indirect investors in these subprime loans had been banks. The banks had lent money to investment companies that had invested in mortgages. When the mortgages started to go bad, many investment funds blew up and couldn t repay the loans they had taken out from the banks. The banks had to write off (declare unrecoverable) the loans they had made to the investment funds. Doing so meant reducing the banks reserves, which in turn limited their ability to generate new loans. This was a major threat to the economy since both consumers and businesses rely on loans to finance consumption and investment expenditures. In the second half of 2007 and into early 2008, the Federal Reserve took several important steps to increase bank reserves and avert a financial crisis. In August 2007, it fulfilled its important (but thankfully rarely needed) role as a lender of last resort by lowering the discount rate and encouraging banks to borrow reserves directly from the Fed. When many banks proved reluctant to borrow reserves at the discount rate (because they thought that doing so might make them appear to be in bad financial condition and in need of a quick loan from the Fed), the Fed introduced the anonymous term auction facility in December as an innovative new way of encouraging banks to borrow reserves and thereby preserve their ability to keep extending loans. Most importantly, the FOMC lowered the target for the Federal funds rate first from 5.25 percent to 4.75 percent in September, then to 4.50 percent in October, down to 4.25 percent in December, and then down to 2 percent in April To accomplish these rate cuts, it bought bonds in the open market and auctioned off reserves. The greater reserves expanded bank lending. The lower Federal funds rate also resulted in lower interest rates in general, thereby bolstering aggregate demand. Many observers had been worried that the mortgage debt crisis might lead nervous consumers and businesses to cut back on spending out of fear that the crisis might increase the likelihood of a recession. By increasing aggregate demand, the Fed decreased this possibility and reassured both consumers and businesses about the economy s prospects going forward. A strange thing about the crisis was that before it happened, banks had mistakenly believed that an innovation known as the mortgage-backed security had eliminated their exposure to mortgage defaults. Mortgage-backed securities are a type of bond backed by mortgage payments. To create them, banks and other mortgage lenders would first make mortgage loans. But then instead of holding those loans as assets on their balance sheets and collecting the monthly mortgage payments, the banks and other mortgage lenders would bundle hundreds or thousands of them together and sell them off as a bond in monetary policy suffers from a You can lead a horse to water, but you can t make it drink problem. The Fed can create excess reserves, but it cannot guarantee that the banks will actually make additional loans and thus increase the supply of money. If commercial banks seek liquidity and are unwilling to lend, the efforts of the Fed will be of little avail. Similarly, businesses can frustrate the intentions of the Fed by not borrowing excess reserves. And the public may use money paid to them through Fed sales of U.S. securities to pay off existing bank loans, rather than on increased spending on goods and services. Furthermore, a severe recession may so undermine business confidence that the investment demand curve shifts to the left and frustrates an expansionary monetary policy. That is what happened in Japan in the 1990s and early 2000s. Although its central bank drove the real interest rate to 0 percent, investment spending remained low and the Japanese economy stayed mired in recession. In fact, deflation a fall in the price level occurred. The Japanese experience reminds us that monetary policy is not a certain cure for the business cycle. In March 2003 some members of the Fed s Open Market Committee expressed concern about potential deflation in the United States if the economy remained weak. But the economy soon began to vigorously expand, and deflation did not occur. (Key Question 8) 682

24 essence selling the right to collect all of the future mortgage payments. The banks would get a cash payment for the bond and the bond buyer would start to collect the mortgage payments. From the banks perspective, this seemed like a smart business decision because it transferred any future default risk on those mortgages to the buyer of the bond. The banks thought that they were off the hook. Un fortunately for them, however, they lent a substantial portion of the money they got selling the bonds to investment funds that invested in mortgage-backed bonds. So while the banks were no longer directly exposed to mortgage default risk, they were still indirectly exposed to it. And so when many homebuyers started to default on their mortgages, the banks still lost money. But what had caused the skyrocketing mortgage default rates in the first place? There were many causes, including declining real-estate values. But an important factor was the bad incentives provided by the bonds. Since the banks and other mortgage lenders thought that they were no longer exposed to mortgage default risk, they became very sloppy in their lending practices so much so that people were granted subprime mortgage loans that they were very unlikely to be able to repay. Some mortgage companies were so eager to sign up new homebuyers (in order to bundle their loans together to sell bonds) that they stopped running credit checks and even allowed applicants to claim higher incomes than they were actually earning in order to qualify for big loans. The natural result was that many of these people took on too much mortgage and were soon failing to make their monthly payments. Politicians and financial regulators are now examining whether tighter lending rules would help to offset the pass the buck incentives created by mortgagebacked securities and prevent loans from being issued to people who are very unlikely to be able to make the required monthly payments. They also are considering ways to help homeowners who took on too much debt to remain in their homes since defaults on these loans would increase the supply of homes for sale in the real estate market and reduce house prices, which in turn could produce further defaults and reduce confidence in the overall economy. QUICK REVIEW 33.4 The Fed is engaging in an expansionary monetary policy when it increases the money supply to reduce interest rates and increase investment spending and real GDP; it is engaging in a restrictive monetary policy when it reduces the money supply to increase interest rates and reduce investment spending and inflation. The Fed managed low inflation and strong growth during the 1990s. The crises of 9/11 and the 2001 recession caused the Fed to lower rates aggressively, which it did again during the mortgage debt crisis that started in The main strengths of monetary policy are (a) speed and flexib ility and (b) political acceptability; its main weaknesses are (a) time lags and (b) potential ineffectiveness during severe recession. The Big Picture Figure 33.6 (Key Graph) on pages 680 and 681 brings together the analytical and policy aspects of macroeconomics discussed in this and the eight preceding chapters. This big picture shows how the many concepts and principles discussed relate to one another and how they constitute a coherent theory of the price level and real output in a market economy. Study this diagram and you will see that the levels of output, employment, income, and prices all result from the interaction of aggregate supply and aggregate demand. The items shown in red relate to public policy. 683